Professional Documents
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The proposed FDI and licensing will be evaluated using the net present value of relevant cash flows to the UK.
Forecast exchange rates using purchasing power parity:
Spot
Year 1
Year 2
Year 3
Year 4
Year 5
$H/
1580
1704
1787
1873
1964
2060
Bt/
420
432
441
449
458
467
$H/Bt
376
394
405
417
429
441
1
150
76
23
99
51
(10)
41
$H million
2
3
405
437
174
188
40
40
51
52
17
17
282
297
123
140
(25)
(28)
98
112
17
17
4
472
203
40
54
17
314
158
(32)
126
17
5
510
219
40
55
17
331
179
(36)
143
17
(4)
139
(4)
150
306
(120)
(35)
(70)
(68)
(4)
(155)
(101)
112
0
(981)
1
(593)
(030)
2
627
(069)
050
3
673
(075)
049
4
708
(080)
048
5
1485
(087)
047
(051)
557
0769
428
(053)
594
0675
401
(055)
621
0592
368
(056)
1389
0519
721
(3)
(3)
126
million
Year
Remittable from H
Extra tax (10%)
Remittable from B1
Incremental cash flow
from machinery
Tax on profit (30%)
Lost exports (after tax)2
Net cash flow
Discount factors (14%)3
Present values
(981)
(981)
100
(030)
(050)
(603)
0877
(529)
Lost exports are assumed to increase with UK inflation. It might be argued that such losses would continue beyond five years
and have a more detrimental effect on cash flows.
15
Working capital requirements in Hotternia are assumed to increase at the rate of inflation in Hotternia.
Licensing
Year
Receipts from fees $H
Receipts from fees
Incremental cash flow
from maintenance
Incremental cash flow
from machinery
Staff costs
Taxable
Tax at 30%
Lost exports (after tax)4
Net cash flows
Discount factors (14%)
Present values
2
4000
224
million
3
4
4320
4666
231
238
5
5039
245
025
025
025
025
(021)
228
(068)
160
(051)
109
0769
084
(022)
234
(070)
164
(053)
111
0675
075
(022)
241
(072)
169
(055)
114
0592
067
(023)
247
(074)
173
(056)
117
0519
061
100
100
(030)
070
070
0877
061
The financial analysis suggests that foreign direct investment is the better choice, as it results in a higher expected NPV.
Other information that might influence the decision includes:
(i)
Are there strategic reasons for preferring a specific method of market entry?
(ii)
What happens after five years? Would the licence be renewed? Do real options exist for each alternative and if so what is their
expected net present value?
(iii) How accurate are the cash flow projections? Simulation analysis or sensitivity analysis would be useful.
(iv) How reliable is KBD? Could quality be maintained and is there the risk of technology transfer?
(v)
What are the risks of the investments? What are the political and other non-financial risks associated with FDI and licensing?
FDI normally involves much more risk than licensing.
(vi) Does the discount rate of 14% correctly reflect the risk? Licensing should probably be discounted at a lower rate if it is less
risky.
(vii) Is the FDI realisable value estimated using an asset basis or going concern basis? A going concern valuation could be much
higher than an asset based valuation.
(a)
Gap analysis measures the difference between an organisations financial targets and what it expects to achieve given its
existing policies. It is important to estimate the potential size and nature of the gap in order to develop new strategies that
will eliminate the gap and allow the organisation to achieve its stated targets.
(b)
1
5775
million
2
6064
3
6367
3754
980
465
576
140
436
131
305
122
183
3942
980
349
793
127
666
200
466
186
280
4139
980
262
986
108
878
263
615
246
369
16
53%
32%
Repay overdraft
Year
Overdraft at year end
1
767
2
487
3
118
1
1817
3593
506%
2
1537
3873
397%
3
1168
4242
275%
The gearing is expected to fall to below the level required by the covenant.
Notes:
(i)
(ii)
(iii) Working capital, other than the overdraft, is assumed to remain unchanged. In reality this is unlikely.
(c)
(i)
In order to increase retained earnings without adversely affecting any of the other targets Greffer could attempt to
increase sales, whilst maintaining its profit margin, and/or reduce costs through increased productivity, controlling wage
rises or other direct costs, or reducing fixed costs.
(ii)
(d)
Free cash flow to the firm is cash flow before any interest payments, but after tax on operating cash flows. From the data
provided free cash flow to the firm will be defined as:
EBIT (1 tax rate)
+ Capital allowances
Investment expenditure
+/ Change in non-cash working capital (assumed to be zero in b(iii))
Free cash flow ( million)
Year
EBIT (1-t)
Capital allowances
Change in working capital
Capital Investment
1
4032
4650
2
5551
3490
3
6902
2620
8682
0893
7753
9041
0797
7206
9522
0712
6780
5973
After year 3
6902
3500
(4000 )
6402/12
0712
3799
This is the free cash flow of the firm. To find the value of equity debt must be deducted
5973 2000 debt
40 million shares
The current share price is higher than that estimated using free cash flow analysis. However, the free cash flow projections
are subject to a number of simplifying assumptions which limit the potential accuracy of the analysis.
17
(a)
Shares held(000)
250
400
120
310
1,435
Market value()
1,850,000
2,040,000
1,368,000
1,131,500
1,406,300
7,795,800
MV x Beta
2,497,500
2,570,400
1,573,200
927,830
2,320,395
9,889,325
9,889,325
The portfolio beta is: = 1269
7,795,800
The contract size is the current index value of 5930 x 10 = 59,300. (NB In some futures markets the contract size could
be the futures price of 5,950 x 10 = 59,500. This is an acceptable answer.)
As the portfolio beta is higher than the index beta (assumed to be the market beta of 1), the hedge must be adjusted for the
additional risk of the portfolio.
Hedge:
7,795,800
Sell x 1269 = 16683 or 167 contracts
59,300
Options on stock index futures
Futures have the disadvantage of locking into an expected outcome, no matter how the associated cash market has
performed. Options on futures allow the buyer of the option to either exercise the option and fix a worst case outcome, or, if
market prices move in favour of the investor, to let the option lapse. In this case if the stock index was to rise above the
relevant exercise price the option would not be exercised.
September put options should be purchased.
If Trenter wishes to protect current share prices, the closest option to the current index price of 5930 should be selected,
which is 5925.
As with futures 167 contracts should be purchased. If the stock index value falls to below 5925 by the time of expiry of the
option, the option would be exercised and futures sold at 5925 but immediately repurchased at a lower price to close out the
deal and generate a profit. If the index value moved above 5925 the contract would not be exercised. The disadvantage of
the option is that a premium of 108, or 108 x 10 = 1,080 per contract has to be paid to purchase the option. For 167
contacts this is 180,360, or approximately 23% of the portfolio value. This is a relatively expensive form of hedge.
Synthetic short position
The cost of an option hedge may be reduced by creating a synthetic short position. This would involve buying a put option
with an exercise price of 5925 as above, but simultaneously selling a call option at the same exercise price. This would result
in net premium paid of (1080 1400) x 10 x 167 = (53,440), i.e. a net receipt.
This hedge protects against downside risk, but also takes away any potential benefit if market prices were to increase. It has
created a synthetic short future.
(b)
7,113,500
The market value of the shares has fallen by 682,300
18
609,550
89% x 100%
682,300
(a)
Fader
441
= 11025 pence
40
287
= 9567 pence
30
PE ratios:
(b)
Doubler
Fader
290 pence
= 2630
11025 pence
180 pence
= 18 81
9567 pence
A 2-for-3 share exchange will result in the issue of 30 million x 2/3 new shares, or 20 million shares, giving a total of
60 million shares.
million
Current combined earnings after tax
728
Additional earnings from operating savings 075
803
Ignoring the one-off redundancy payments the expected earnings per share is:
803
= 1338 pence
60
Increasing earnings per share alone is not enough. The effect on the market value is the crucial factor. When a relatively high
PE company acquires a company with a lower PE, the expected earnings per share will increase, but not necessarily the total
market value of the companies.
(c)
(i)
19
(ii)
(700,000)
5,550,000
If the market is efficient the market value of the combined company should increase by 5,550,000 as a result of the
expected increase in NPV, much less than the estimate using PE based valuation.
(d)
Both estimates are likely to be inaccurate. Many other factors are likely to affect the post acquisition share price. For example:
(i)
(ii)
There may be problems integrating the operations and workforce of the two companies.
(iii) Doublers managers may be able to apply enhanced management skills to Faders operations.
(iv) The effect of the change in risk and capital structure is not known.
With respect to the PE estimate:
(i)
(ii)
Accurate estimates of future earnings are very difficult, and earnings can rapidly change.
The value of all expected cash flows pre and post acquisition should be compared, not just the changes in a few cash
flows. However, post acquisition cash flows are very difficult to determine.
(ii)
(iii) The cost of capital of Doubler is likely to change as a result of the acquisition of Fader.
(a)
Money market hedges are available, either directly in the Blundonian peso or as a cross hedge in $US. A forward market
cross hedge is also possible.
Money market hedges lock in the expected cash flow from a foreign exchange transaction by utilising both interest rates and
exchange rates. They do not however allow the hedger to benefit from favourable movements in the spot rate. The peso hedge
also runs the risk that the government will block the outflow of funds from Blundonia.
Money market hedge:
Immediately, borrow B pesos 96,618,357 at 14% per year (100m/1035)
Convert at the spot rate of P1282/ into 753,653
Use the funds to reduce the UK overdraft at 6% per annum, 753,653 x 1015 = 764,958.
This is the effective receipt in three months time.
Assuming the funds are not needed for other purposes it is better for them to be used to repay some of the overdraft rather
than invest in the UK money market.
Cross hedges via the dollar are risky. Although the peso is fixed against the $US, the much higher inflation rate in Blundonia
suggests that there will be pressure on the Blundonian government to devalue the peso from its current fixed rate. If a
devaluation was to occur during the next three months cross hedges would not be effective. Additionally funds still have to
be remitted from Blundonia to the USA in order to fulfil the hedges.
The spot cross rates between the B peso and the $ are P7093 7223/$
100m pesos
= $1,384,466
7223
Cross forward hedge:
Sell $1,384,466 3 months forward at $1789/ = 773,877
(The $1,384,466 would be bought using the 100 million pesos at the spot rate of
P7223/$, assuming the fixed rate between the peso and dollar does not change.)
Forward hedges are easy to arrange via banks, lock in the expected future cash flow, but, in common with money market
hedges, do not allow the hedger to take advantage of favourable currency movements.
20
After a 15% discount the excepted receipts are 985 million pesos
Converted at spot of P1282/ this yields 768,331
Use to repay part of the overdraft. 768,331 x 1015 = 779,856.
This is more beneficial for Tertial and should be agreed.
(c)
Tertial could use the 100m pesos to invest in Blundonia, but as the company has only just commenced exports this is unlikely
to be a favoured alternative.
A counter-trade deal is possible, where the 100m pesos are used to purchase goods in Blundonia. The goods might be sold
to a third party outside Blundonia. The third party would pay Tertial an agreed equivalent sum in sterling or another acceptable
hard currency. This form of transaction should be acceptable to the Blundonian government as it does not involve cash
leaving the country.
There are many possible answers to this question. The solution suggested below is indicative only.
Ethics impact on many aspects of investment decisions. In theory companies seek to maximise shareholder wealth, often subject
to constraining secondary objectives. Such secondary objectives include the welfare of the public. Companies are affected by
ethical standards relating to:
(i)
Health and safety. Employees and the public should be protected from danger, which includes working conditions, effective
employment law and product safety.
(ii)
Environmental issues such as controlling pollution, protecting wildlife and the countryside.
Fully satisfying these issues might be an expensive element in a capital investment.
(iii) Bribes and other payments. Investment might proceed more quickly and efficiently if bribes, incentive payments, gifts etc.
are paid to officials. This is a difficult area, as gifts are part of the business culture in some countries. Even the ethics of
political contributions is debatable.
(iv) Corporate governance. Many examples exist of companies , e.g. Enron, where the results of investments and the true financial
position have been hidden from shareholders and the public.
(v)
Taxation. Companies may try to minimise their tax liability. Tax evasion is illegal, but there is an ethical question over the use
of sophisticated tax avoidance measures, especially in developing countries.
(vi) Wage levels. Should a company pay low wages to maximise shareholder wealth, especially in countries where the standard
of living is very low?
(vii) Individual managers ethics. The ethics of individuals, including pursuing their own goals and self interest (such as job
security) rather than those of the organisation might influence the outcome of investment decisions.
There is inevitably some subjectivity as to what constitutes ethical behaviour, but there is little doubt that ethical issues are of
increasing importance to companies. Acting in an ethically responsible way often has a direct detrimental impact upon expected
cash flows and NPV. However, stakeholders, including shareholders, are increasingly expecting companies to act ethically. If they
do not, then their share price might suffer as a result of adverse publicity and investors withdrawing their support.
The concept of ethical shareholder wealth creation is likely to become increasingly important in strategic financial management.
21
This question requires analysis of alternative methods of entering foreign markets, including the financial
and non-financial analysis of a potential foreign direct investment and licensing.
Criterion(a) for the decision
Exchange rate forecasts
(need all three sets for maximum marks)
FDI
Cash flows in Hotternia:
Sales
Variable costs
Component
Deprecation
Tax
Add back deprecation
Costs and realisable value
Working capital
UK cash flows:
Extra tax
Remittable from Bottoniland
Machinery plus tax
Lost exports (after tax)
Discount rate
NPV
Licensing
Receipts
Maintenance profit
Costs
Lost exports
Tax
NPV
1
4
1
1
2
1
1
2
2
2
2
1
1
2
2
1
1
1
1
1
1
1
max 31
Other information. 12 marks for each good point. 2 especially relating to strategy and risk.
23
max 9
Total 40
Marks
2
This question requires critical analysis of a companys financial planning targets, and estimates of whether
or not targets are likely to be achieved. It also requires understanding of free cash flow and how to produce
a free cash flow valuation .
(a)
(b)
Financial projections:
Sales/VC/FC
Capital allowance
Interest
Dividends
Retained earnings
Target calculations:
Growth rates
Gearing/covenant
Repayment of overdraft
Relevant assumptions and comment
1
1
1
1
1
1
3
3
1
max 12
(i)
(ii)
(d)
(a)
(b)
2
max 5
2
5
1
Total 30
1
1
1
1
1
1
1
1
max 2
max 9
1
max 2
max 2
max 2
max 6
Total 15
24
(a)
EPS
PE ratios
(b)
(c)
(i)
(ii)
Cash flow:
Marks
1
1
2
1
1
2
4
2
PV of operating savings
Overall change in cash flow
(d)
(a)
2
1
max 4
Total 15
3
1
1
2
max 9
(b)
max 3
(c)
max 3
Total 15
25
1011
45
Maximum 15